Contractor or employee? New IRS audits turn up heat on worker misclassification

If your organization uses independent contractors, watch out: Starting in February, the IRS will begin intensive audits of 6,000 randomly selected employers. One of the key targets: Determining whether employers are improperly misclassifying workers as independent contractors to save on taxes and legal risks.

The National Research Program (NRP) audits will generate the IRS’s first statistical snapshot of employment tax compliance since 1984. The audits will stretch across all industries and company sizes.

Federal officials believe the recession has encouraged more employers to classify members of their workforce—often incorrectly—as independent contractors. Classifying workers as independent contractors can save money for the employer, as they don’t have to pay for contractors’ benefits or for the employers’ half of the Social Security and Medicare taxes on workers’ wages.

The fault line in the great Employee or Contractor divide lies in how much control the employer has over the worker’s schedule, materials, behavior, risk level, etc. 

A recent U.S. Government Accountability Office (GAO) report says employee misclassification “could be a significant problem with adverse consequences” because it reduces tax revenues flowing to the government.

The last time the IRS did a study of misclassification in 1984, it estimated that about 15% of employers nationally misclassified a total of 3.4 million employees as independent contractors. A Bureau of Labor Statistics report in 2005 reported that 10.3 million American workers—or about 7.4% of the workforce—were classified as independent contractors.

FedEx is the poster child for the contractor battle. The IRS originally hit the company with a $319 million tax assessment for improperly classifying 12,000 of its drivers as independent contractors. But earlier this month, the IRS backed off the assessment and allowed the workers to be classified as employees. Still, several states aren’t giving up the fight … they plan to sue FedEx over those classifications.

The GAO report says that the number of misclassified workers uncovered by state audits had increased from approximately 106,000 workers in 2001 to more 150,000 workers in 2007. And states are becoming much more active in passing laws to prevent misclassifications (see box below).

The 6,000 NRP audits will include face-to-face interviews, plus a line-by-line review of the company’s employment tax returns (IRS Form 941) and related forms and documents. Audits will mainly focus on tax returns for the calendar years 2007 and 2008.  

How to respond if you are audited?

You can’t do anything to avoid being targeted under this audit program. But there are certain steps you can take in response to this shift in the IRS policing of employment tax compliance. Here are some tips from the Society for Human Resource Management (SHRM):

• Your tax and payroll departments should review the company’s current payroll practices, with a specific focus on the five areas identified by the NRP initiative, as well as any other known areas of weakness.
• Review the condition of your three most recent years’ employment tax returns, as well as all supporting documents and records. In most cases, the company’s third-party payroll administrator can assist with this process.
• If your company is selected for examination, good IRS examination management practices should be followed, including these steps: 1) Designate a clear “chain of command” for responding to audit notices and other IRS communications. 2) Retain expert outside advisors early in the process. 3) Maintain control over the IRS audit by requesting additional time to respond to information document requests, or tailoring the scope of information requested, where appropriate.